This paper analyzes the effect of firing costs on aggregate productivity growth. For this
purpose, a model of endogenous growth through selection and imitation is developed. It
is consistent with recent evidence on firm dynamics and the contribution of firm entry and
exit to aggregate productivity growth. In this model, growth arises endogenously via market
selection among heterogeneous incumbent firms. It is sustained as entrants imitate the best
incumbents. In this framework, besides inducing misallocation of labor and reducing entry,
firing costs also discourage exit of low-productivity firms. This makes selection less severe
and reduces growth. However, exempting exiting firms from firing costs speeds up the exit
of inefficient firms and thereby growth, with little change in job turnover. These effects are
stronger in sectors where firms face larger idiosyncratic shocks, as in services, fitting evidence
that here, EU-US growth rate differences are largest. Introducing firing costs of one year’s
wages in a benchmark economy calibrated to the US business (services) sector then leads to
0.1 (0.3) points lower growth. A brief empirical analysis of the impact of firing costs on the
size of exiting firms supports the model’s conclusions.